Felix Salmon Tries to Puzzle Out Tim Geithner's Thinking: The Government Needs to Lend to Banks Freely But at a Penalty Rate Blogging

“The central paradox of financial crises,” Timothy F. Geithner, the Treasury secretary, said before leaving for the Group of 20 meetings in Europe last week, “is that what feels just and fair is the opposite of what’s required for a just and fair outcome.”

This is textbook Geithner. For one thing, it’s pure Technocrat. Geithner, here, is the worldly policy wonk, explaining why it’s silly to simply do what feels right. In fact, you should do what feels wrong! The quote is also extremely defensive — as it probably should be, coming from the one member of Obama’s economic team who played a central part in orchestrating the Bush bailouts. And I can’t help but see the influence of Occupy Wall Street here, too. They’re demanding justice; and Geithner is, essentially, dismissing them as unsophisticated rubes. If only they understood what he understands — then they’d see that the bailouts were in their own best interest! Still, they’re setting the terms of the debate — to the point at which Geithner now considers such questions “central” to financial crises in general. (I don’t recall him talking that way when he was at the New York Fed.)…

Plus there is the fact that--at least as I see it--Geithner is not accurate. The policies that I at least think would be technocratically best are policies that would, by and large, feel just and fair.

Back when Martin Wolf was taunting Larry Summers about how useless economics was, Summers said: "There is a lot that is useful about the financial crisis in Bagehot." Walter Bagehot (1873), Lombard Street, is the nineteenth century's manual for dealing with a financial crisis. It says that in a financial crisis the central bank should:

lend freely

at a penalty rate

Lend freely: The first-order problem is that the market has seen a sudden rise in the share of their portfolios that investors wish to hold in cash--for safe, liquid, savings vehicles--just as events and then the fallout from the crisis itself diminishes the supply of cash The central bank by lending freely to debtors can turn their liabilities that are no longer cash--no longer regarded as safe, and hence no longer liquid, and dubious as savings vehicles--back into cash. Moreover, confidence that the crisis will not spiral out of control will reduce the demand for cash. And so the economy and the financial crisis will right itself.

At a penalty rate: The second-order problem is that the failures of risk management and of foresight that caused the crash and crisis need to be punished and not rewarded. If the financiers whose over leverage set the stage for the disaster emerge wealthier than ever and even more confident that the government will bail them out, you have created an economic and political disaster. The disaster is economic in that you have just given incentives to create bigger episodes of moral hazard and bigger financial crises in the future. The disaster is political because voters will conclude that you are wholly-owned tools of Wall Street, and there is no way an outcome that leaves over leveraged financiers still in the game and as wealthy and ever can be or be sold as just and fair.

"But", Geithner might say, "we couldn't lend at a penalty rate! These banks were not only illiquid but insolvent. If we had lent them money at a high interest rate that would not have made their other liabilities safer but riskier." That is, I think, largely true. And that is very important.

However, in that case there is a corollary to the Bagehot rule: if the institutions that need to be to supported are too weak to be able to stand being lent to at a penalty rate, take equity. If they are just illiquid, they can afford to pay a penalty rate. If they are truly insolvent, their equity is valueless--or, rather, their equity has value only insofar as people are pricing in a possible government bailout. In that case you can--if you really think it advisable--support the over leveraged banks, but the form your support must take is the form of equity: you need to grab the upside for the government and the people. A large part of the bounce-back of JPMorganChase's stock price from the 25 or so it was at the end of 2008 to the 40 or so it has been in 2010 was a present given to JPMorganChase's shareholders by the federal government. It would be only just and fair if a large chunk of that appreciation had flowed to the Treasury--and taking equity would have made that happen.

This solves the economic problem: zeroing out equity and options holders provides a healthy vaccination against future moral hazard. This solves the political problem: the gains to the financial sector from the recovery go to the Treasury and thus to the people. And this goes some way toward solving the moral problem as well--especially when coupled with a more progressive tax system.

"But", Geithner might say, "we needed all the big overleveraged banks to accept help: if we had offered help only to those banks that agreed to let us make equity investments, a bunch would have held back, and failed, and that would have generated chaos." It is certainly true that policies of taking a tougher line with the overleveraged banks would have entailed risks. However, in the end I think that the risks were relatively small. Thus I disagree with Geithner: when push came to shove and there was blood on the streets and it was clear that government help was not coming in any form other than government purchases of equity at distressed fire-sale valuations, bank directors would have taken the deal to preserve some of their old equity value and to preserve their institutions. And the longer a bank delays, the lower its equity value falls and the larger the share of profits from the recovery that flow to the Treasury.

As it is--well, Felix Salmon also reports that Zachary Goldfarb gets an equal-and-opposite quote from Neil Barofsky, whom he calls the Geithner antiparticle:

“There’s a very popular conception out there that the bailout was done with a tremendous amount of firepower and focus on saving the largest Wall Street institutions but with very little regard for Main Street,” said Neil Barofsky, the former federal watchdog for the Troubled Assets Relief Program, or TARP, the $700 billion fund used to bail out banks. “That’s actually a very accurate description of what happened.”

Goldfarb goes into chapter and verse explaining what Barofsky is talking about — the way that too-big-to-fail banks have gotten ever bigger and more profitable, at the expense of the rest of us. And after reading his article, it’s extremely difficult to understand what Geithner might be talking about. Does he think that what we’ve seen on Wall Street in the past year or two is a “just and fair outcome”? If not, is he saying that he did “what feels just and fair” instead of what was the right thing to do?

What’s undeniable is that Barofsky is easy to understand, while Geithner is being cryptic and opaque. That might be because Leonhardt didn’t give him enough space to explain himself more fully, or it might be because Geithner simply isn’t a great communicator. But knowing the Treasury press office, I suspect that negotiations between Leonhardt and Treasury were required before Geithner’s quote became on-the-record. Which does make me wonder what they thought that they were saying here.

If you would ask me to guess at what Geithner's position was, I think it is the following:

The economy cannot withstand a finance strike.

High finance knows that the economy cannot withstand a finance strike, and thus believes it has immense bargaining power.

Moreover, financiers are not sharp-eyed cold-hearted calculators: if they believe that the Treasury is no treating them well--that the Treasury seeks an outcome that they would call "socialistic"--they may call a finance strike anyway.

These are my guesses, anyway: that in a financial crisis the overleveraged bankers have the economy by the plums, and technocratic wisdom is to recognize this and accommodate yourself to it. There is considerable truth to this.

Thus my impression is that Geithner and his Treasury staff thinks that while it would have been nice to have provided support to the banking system in a form that got the Treasury more of the upside, that that was and is a side issue. A potential Great Depression was stopped in its tracks. And, relative to the $15 trillion or more of economic losses that were thus avoided, the fact that the TARP will, properly accounted, lose $100 billion rather than making $200 billion is rounding error.

I am not sure whether or not that is a correct economic argument--in fact, I am pretty sure that it is not: the benefit of TARP profitability is then that the TARP would have been not an enabler of but instead a vaccination against future moral hazard.

I am sure that that is a lousy political argument. The fact that the U.S. Treasury profited from its interventions in Mexico in 1994-96 was an important piece of the political landscape back in the political years.

“The central paradox of financial crises,” Timothy F. Geithner, the Treasury secretary, said before leaving for the Group of 20 meetings in Europe last week, “is that what feels just and fair is the opposite of what’s required for a just and fair outcome.”

This is textbook Geithner. For one thing, it’s pure Technocrat. Geithner, here, is the worldly policy wonk, explaining why it’s silly to simply do what feels right. In fact, you should do what feels wrong! The quote is also extremely defensive — as it probably should be, coming from the one member of Obama’s economic team who played a central part in orchestrating the Bush bailouts. And I can’t help but see the influence of Occupy Wall Street here, too. They’re demanding justice; and Geithner is, essentially, dismissing them as unsophisticated rubes. If only they understood what he understands — then they’d see that the bailouts were in their own best interest! Still, they’re setting the terms of the debate — to the point at which Geithner now considers such questions “central” to financial crises in general. (I don’t recall him talking that way when he was at the New York Fed.)…

Plus there is the fact that--at least as I see it--Geithner is not accurate. The policies that I at least think would be technocratically best are policies that would, by and large, feel just and fair.

Back when Martin Wolf was taunting Larry Summers about how useless economics was, Summers said: "There is a lot that is useful about the financial crisis in Bagehot." Walter Bagehot (1873), Lombard Street, is the nineteenth century's manual for dealing with a financial crisis. It says that in a financial crisis the central bank should:

lend freely

at a penalty rate

Lend freely: The first-order problem is that the market has seen a sudden rise in the share of their portfolios that investors wish to hold in cash--for safe, liquid, savings vehicles--just as events and then the fallout from the crisis itself diminishes the supply of cash The central bank by lending freely to debtors can turn their liabilities that are no longer cash--no longer regarded as safe, and hence no longer liquid, and dubious as savings vehicles--back into cash. Moreover, confidence that the crisis will not spiral out of control will reduce the demand for cash. And so the economy and the financial crisis will right itself.

At a penalty rate: The second-order problem is that the failures of risk management and of foresight that caused the crash and crisis need to be punished and not rewarded. If the financiers whose over leverage set the stage for the disaster emerge wealthier than ever and even more confident that the government will bail them out, you have created an economic and political disaster. The disaster is economic in that you have just given incentives to create bigger episodes of moral hazard and bigger financial crises in the future. The disaster is political because voters will conclude that you are wholly-owned tools of Wall Street, and there is no way an outcome that leaves over leveraged financiers still in the game and as wealthy and ever can be or be sold as just and fair.

"But", Geithner might say, "we couldn't lend at a penalty rate! These banks were not only illiquid but insolvent. If we had lent them money at a high interest rate that would not have made their other liabilities safer but riskier." That is, I think, largely true. And that is very important.

However, in that case there is a corollary to the Bagehot rule: if the institutions that need to be to supported are too weak to be able to stand being lent to at a penalty rate, take equity. If they are just illiquid, they can afford to pay a penalty rate. If they are truly insolvent, their equity is valueless--or, rather, their equity has value only insofar as people are pricing in a possible government bailout. In that case you can--if you really think it advisable--support the over leveraged banks, but the form your support must take is the form of equity: you need to grab the upside for the government and the people. A large part of the bounce-back of JPMorganChase's stock price from the 25 or so it was at the end of 2008 to the 40 or so it has been in 2010 was a present given to JPMorganChase's shareholders by the federal government. It would be only just and fair if a large chunk of that appreciation had flowed to the Treasury--and taking equity would have made that happen.

This solves the economic problem: zeroing out equity and options holders provides a healthy vaccination against future moral hazard. This solves the political problem: the gains to the financial sector from the recovery go to the Treasury and thus to the people. And this goes some way toward solving the moral problem as well--especially when coupled with a more progressive tax system.

"But", Geithner might say, "we needed all the big overleveraged banks to accept help: if we had offered help only to those banks that agreed to let us make equity investments, a bunch would have held back, and failed, and that would have generated chaos." It is certainly true that policies of taking a tougher line with the overleveraged banks would have entailed risks. However, in the end I think that the risks were relatively small. Thus I disagree with Geithner: when push came to shove and there was blood on the streets and it was clear that government help was not coming in any form other than government purchases of equity at distressed fire-sale valuations, bank directors would have taken the deal to preserve some of their old equity value and to preserve their institutions. And the longer a bank delays, the lower its equity value falls and the larger the share of profits from the recovery that flow to the Treasury.

As it is--well, Felix Salmon also reports that Zachary Goldfarb gets an equal-and-opposite quote from Neil Barofsky, whom he calls the Geithner antiparticle:

“There’s a very popular conception out there that the bailout was done with a tremendous amount of firepower and focus on saving the largest Wall Street institutions but with very little regard for Main Street,” said Neil Barofsky, the former federal watchdog for the Troubled Assets Relief Program, or TARP, the $700 billion fund used to bail out banks. “That’s actually a very accurate description of what happened.”

Goldfarb goes into chapter and verse explaining what Barofsky is talking about — the way that too-big-to-fail banks have gotten ever bigger and more profitable, at the expense of the rest of us. And after reading his article, it’s extremely difficult to understand what Geithner might be talking about. Does he think that what we’ve seen on Wall Street in the past year or two is a “just and fair outcome”? If not, is he saying that he did “what feels just and fair” instead of what was the right thing to do?

What’s undeniable is that Barofsky is easy to understand, while Geithner is being cryptic and opaque. That might be because Leonhardt didn’t give him enough space to explain himself more fully, or it might be because Geithner simply isn’t a great communicator. But knowing the Treasury press office, I suspect that negotiations between Leonhardt and Treasury were required before Geithner’s quote became on-the-record. Which does make me wonder what they thought that they were saying here.

If you would ask me to guess at what Geithner's position was, I think it is the following:

The economy cannot withstand a finance strike.

High finance knows that the economy cannot withstand a finance strike, and thus believes it has immense bargaining power.

Moreover, financiers are not sharp-eyed cold-hearted calculators: if they believe that the Treasury is no treating them well--that the Treasury seeks an outcome that they would call "socialistic"--they may call a finance strike anyway.

These are my guesses, anyway: that in a financial crisis the overleveraged bankers have the economy by the plums, and technocratic wisdom is to recognize this and accommodate yourself to it. There is considerable truth to this.

Thus my impression is that Geithner and his Treasury staff thinks that while it would have been nice to have provided support to the banking system in a form that got the Treasury more of the upside, that that was and is a side issue. A potential Great Depression was stopped in its tracks. And, relative to the $15 trillion or more of economic losses that were thus avoided, the fact that the TARP will, properly accounted, lose $100 billion rather than making $200 billion is rounding error.

I am not sure whether or not that is a correct economic argument--in fact, I am pretty sure that it is not: the benefit of TARP profitability is then that the TARP would have been not an enabler of but instead a vaccination against future moral hazard.

I am sure that that is a lousy political argument. The fact that the U.S. Treasury profited from its interventions in Mexico in 1994-96 was an important piece of the political landscape back in the political years.

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